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Small Business: The Job Engine Needs Fuel

February 28, 1993

Finance: Commentary

SMALL BUSINESS: THE JOB ENGINE NEEDS FUEL

Small and midsized companies are America's secret economic weapon--nimble, entrepreneurial, and innovative. These incubators of growth created 80% of the jobs in the 1980s. That's why helping small business is a key part of the economic package that Bill Clinton unveiled on Feb. 17.

There's just one problem: Small business may not be up to the task. According to a December survey by the National Federation of Independent Business, only 13% plan to expand employment in 1993, and 10% plan reductions. The main obstacle is that small companies are having lots of trouble getting money from their traditional sources--banks and insurers. Despite the economic recovery, bank loans are way down from 1989, and insurer-provided private placements, which usually go to smaller fry, are even worse (charts). The recovery may bring more lending, but not enough.

TOO SAFE. Look at Amlack Inc., a Newark (N. J.) chemical company now shuttered for want of capital. In 1991, after 10 years in business, Amlack closed to retool, which would have allowed it to double its 50-person work force. But then the company's lender failed, and Amlack so far has been unable to get replacement financing. Meanwhile, the company is "dormant," laments Amlack's investment adviser, Anthony L. Alaimo of Coloney Von Soosten & Associates Inc. in Tallahassee, Fla.

Who's to blame? Many people cite stultifying government regulation, a belated response to the 1980s' bacchanal. The Clinton Administration is exploring ways to relax the regulatory burden. All the whining from banks and insurers about a heavy regulatory hand, though, is vastly exaggerated.

The truth is that many U. S. financial institutions, burned by bad loans during the 1980s, have grown too cautious for everybody's good, including their own. Banks would rather make loans to big corporations or simply dine out on the difference between paying 3% for a certificate of deposit and collecting 6% from a medium-term Treasury. In other words, they prefer to fund the federal deficit rather than nurture job-generating small private enterprises that will benefit them and society in the long term.

Banks did make lots of bum loans last decade, but most of the losses involved real estate ventures, not small companies. Indeed, it's possible to make splendid returns on loans to these companies. Good object lessons are available from the handful of investment boutiques, such as New York's Castle Harlan Inc., that focus on financing companies with annual revenues of $150 million or so. The payoff can be handsome, with internal rates of return north of 25% yearly.

Sadly, there aren't enough investment boutiques to make a difference. Castle Harlan's new fund has a mere $250 million to invest. Venture-capital outfits, which historically fund thedinkiest outfits (with annual revenues up to $10 million), last year committed only $2 billion.

Clinton's proposal to reduce the current 28% capital-gains tax on minimum five-year investments in stripling companies--those with less than $25 million in capital--is a misfire. Sure, lowering the levy might trigger some new financing. Trouble is, few businesses that tiny want or need outside equity capital; their owners prefer debt, which doesn't dilute their stake. This proposal will only help them if they sell after five years, not at the start, when they most need money. Besides, why undo the 1986 tax reform, which was all about removing the economic distortion of special tax incentives?

There are plenty of more effective moves the government could make. One is to start a Federal National Mortgage Assn. for small business, which could spur fresh lending to corporate runts by packaging bank loans into securities and selling them to investors. Another good idea: increase the volume of loans guaranteed by the Small Business Administration.

PENSION KITTIES. Although red-tape slashing is no cure-all, the Administration should at least call the banks' bluff and deal with genuine impediments that get in the way of worthy lending. The same goes for state insurance regulators. Two-year-old restrictions on medium-grade private placements, which require insurers to post overlarge reserves as a safeguard, should be relaxed. Default rates for medium-grades are pretty low anyway.

Another ripe area for potential investment capital is pension funds. Much of their billions now is invested in ultrasafe Treasuries. Unfortunately, many have internal rules limiting more speculative investments to a mere 5% of assets. Fund sponsors should relax these restrictions immediately. Considering pension funds' awesome kitties, an additional 5%--or $130 billion--would provide plenty of bread.

In the nation's incubators of growth, feeding time is overdue.Larry Light